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An Adjustment to the Debt Markets

The commercial mortgage backed security (CMBS) market is now mature, with more than $200 billion of annual securitized volume originated in 2006, at least 15 percent growth, and more expected in 2007. The market was initiated in the mid-’80s when portfolio lenders sold off loans backed by commercial real estate assets as a way to diversify, selling excess debt from their books. It soon grew into a way for borrowers to obtain long-term, fixed-rate debt at historically low spreads.

Investors of these securities include large banks, insurance companies, money managers, finance companies, pension funds and hedge funds. In 2000, demand for CMBS exploded in the wake of the dot-com bust, as investors sought a new asset class that provided stable returns. The increase in demand for commercial- and residential-backed securities caused lenders to ramp up their origination efforts to meet demand.

Increased Demand for New Product

With increased investor demand for CMBS, lenders were able to offer attractive pricing with standardized credit requirements. In the past three years, with exponential growth of securitized debt in residential and commercial mortgages, loans hit record-high leverage levels. Lenders designed aggressive structures to compete for borrowers’ business.

From January 2002 to January 2007, the spread on a 10-year, fixed-rate self-storage loan dropped from 250 basis points over the 10-year Treasury to 110 basis points. Amortization (principle pay down) virtually disappeared on self-storage loans, dropping from a 30-year to a 25-year schedule until interest-only periods were finally offered. Debt service coverage (DSC) ratios were reduced from 1.30x to 1.15x, with lenders settling for breakeven deals that showed potential upside. Competitive pressures, coupled with increased demand, helped fuel aggressive underwriting standards and loan structures.

Troubled Waters in the Commercial Sector

On the wave of increased investor appetite, hard-line credit standards became prevalent on other mortgage-backed securities. In the residential mortgage market, sub-prime lending (mortgages made to borrowers with lower than average credit scores), hit all-time highs. But in the mid 2000s, when the residential market cooled and property values declined, sub-prime borrowers could no longer rely on refinancing their homes to keep mortgage payments current.

In recent months, sub-prime defaults have skyrocketed, causing investors in securities backed by these mortgages to suffer downgrades. The crisis has had a global impact on the securitization market, creating credit-quality concerns and limiting investor enthusiasm. It has now been recognized that sub-prime backed securities were over valued in the white-hot real estate market.

With sub-prime defaults at an all-time high and decreased demand for these types of securities, many lenders such as American Mortgage Lending, Mortgage Lender’s Network USA, New Century Financial and Peoples Choice Home Loan were forced to declare bankruptcy. For example, on May 3, 2007, Dillon Read, a UBS hedge fund, closed its doors due to major losses in its asset-backed securities.

Investors in the sub-prime arena suffered heavy losses as defaults continued to mount. Even foreign investors felt the impact. On August 9, 2007, the French bank BNP Paribas SA halted a $2.2 billion investment into three funds that invest in U.S. sub-prime mortgages.

Adjustments in the CMBS Market

In early May 2007, in an effort to avoid a similar collapse in the CMBS market, rating agencies said they would increase subordination levels (the percentage of debt considered below investment grade). These agencies and the investor community cited concerns with decreased underwritten DSC ratios, use of future income in underwriting, increased use of interest-only loans, higher leverage levels, and the looming potential for increased bond defaults.

Rating agencies are charged with valuing asset-backed securities. They judge the integrity of securities sold to investors by underwriting the offerings themselves. Their concerns relate to the continued deterioration of conduit-loan underwriting. This is particularly seen in the increase in leverage, which now far exceeds the benefits of generally positive property fundamentals and a bullish real estate market. The corrective action taken by rating agencies not only caused increased loan spreads, it forced lenders to decrease leverage, increase DSC ratios and reduce interest-only provisions.

While the CMBS market continued to maintain low default rates, the sub-prime meltdown and rating-agency scrutiny caused investors to second guess their investments in CMBS bonds. Essentially, a perfect storm evolved that flooded the market with large amounts of these bonds, creating a significant reduction in investor appetite. For the first time in many years, CMBS lenders are faced with massive losses on their bond offerings and the need to take back unsold bonds while waiting for demand and spreads to improve. It’s important to note that unlike sub-prime, single-family mortgages, commercial real estate collateral has performed well.

This market change has affected borrowers in several ways. Most important, with lenders recognizing losses on their bond sales, spreads are increasing on CMBS debt. For example, the spread on a 10-year, fully leveraged loan jumped from 120 basis points to more than 200 basis points in only weeks. In addition, with a highly illiquid market, some lenders have stopped quoting loans; others have put a halt on early rate locks; and many have had to change spread and deal terms for loans under application and those that were rate-locked. For the first time since 9/11, there has been a large amount of uncertainty in the CMBS market.

A Ray of Hope

The sub-prime issues that led to CMBS volatility have resulted in investor fallout, reduced investor demand and higher spreads. A positive outcome from this is the lenders’ “flight to quality.” As investors look for places to put their money and use the U.S. Treasuries as a haven, the Federal Reserve ponders rate cuts. These events have seen the Treasury yields drop by 50 basis points, from 5.2 percent to 4.7 percent, for the first time in more than a year. The good news is the decline in Treasuries has helped, in part, to offset the widening of loan spreads.

Impact on Alternative Financing

CMBS lenders are not the only ones affected. Portfolio lenders, such as life companies and credit agencies, have easily recognized the disruption in the market and adjusted their spreads accordingly to capture higher yields.

The increase in CMBS spreads also affected the recourse construction-lending market. Many of the lenders size construction dollars based on what a property will qualify for in terms of fixed-rate, take-out debt. With a spread increase, a newly built property will need a higher net operating income to qualify for the same take-out loan. Ultimately, the mortgage backed securitization issues have caused a cut in some construction proceeds as well. This will help keep the supply/demand metrics balanced, and should avoid over-supply issues that could lead to increased commercial-mortgage defaults and more serious long-term effects on the market.

What Does This Mean Now?

Currently, Treasuries are low and spreads are high. To restore some order to the market, investors should focus on the fact that CMBS loans are still performing well and return to buying bonds. This would bring liquidity back to the market, and the demand for CMBS bonds would match supply.

The increase in liquidity would reduce spreads and ease lender exposure. It’s very unlikely that the highly aggressive deal structures offered over the past few years will return anytime soon. The days of full-term, interest-only loans with low DSC, high loan-to-value and underwriting on future income appear to be gone.

The Debt Markets Going Forward

For the markets to move to a more stable footing, investors need to realize greater credit confidence along with reconciliation between price and risk for the investment bonds. Once liquidity and confidence are restored, lenders will once again be able to execute on debt requests.

Lenders, investors and rating agencies will be looking for solid deal fundamentals going forward. These include strong historic or increasing income trends, strong DSC, experienced sponsorship, principle pay down via amortization, cash equity in the transaction, and concrete collateral quality. In short, a loan will need to be sound to attract lender interest. The use of an advisor can help put borrowers at ease, too, as he will be able to provide real-time market feedback in terms of how lenders are pricing.

The correction to the capital markets will likely cause a rise in cap rates as well. Increased debt costs, reduced leverage levels and more demanding DSC requirements will likely impact cap rates and overall property values. This rectification began with the hot residential market, which led to the sub-prime fallout; but once liquidity is restored to the market, long-term, fixed-rate debt should become more predictable, allowing borrowers to fairly gauge the price of money.

Liquidity will come back to the market, but it will be more expensive, and hyper-aggressive loan structures are a thing of the past.

Todd Rhodes is the managing director of risk management for the Real Estate Mortgage Capital Division of RBC Capital Markets, which has originated $2.5 billion in CMBS loans since its inception in fall 2006. RBC Capital Markets is the corporate and investment banking arm of RBC, which sources and securitizes commercial real estate loans on a variety of income-producing properties across the United States. For more information, e-mail todd.rhodes@rbccm.com; visit www.rbccm.com.